Comments to the
Oklahoma Rural Task Force to Access Capital and Financing for Business
Development
August 16, 2005Jonathan Watts Hull, Senior Policy
Analyst
Southern Legislative Conference

The Rural
Lens

It is important that as people
concerned with the health and success of rural America, we look at activities
and policies with a “rural lens.” This means that when any policy action is
considered, its impact on rural communities and the people who live there is
considered, with respect to economic development, too much of economic
development is repeating what worked, which drives investment and resources to
metropolitan areas and industries. Rural places are different in many ways, not
the least of which is the importance to the rural economy of small businesses
and microenterprise. Adding a few jobs to several existing enterprises in a
rural place can have as great and impact for less investment that importing a
new industry from somewhere else. Honoring the existing community asset base,
and building on the advantages rural places have in many ways, will help to map
the path to a more prosperous rural future.

My comments this morning will take a
broad look at the capital available for rural development, with some attention
paid to the role of state government in rural capital. I will focus my
discussion principally on capital for entrepreneurs and rural businesses, with
some discussion of programs to serve communities as well. Finally, I will share
with you a handful of notable programs from around the country that stand out
for their excellence in serving particular needs in their communities or for
their strength in serving rural communities.

I think it will be of use to begin
with what may be review for everyone, but which sets the stage for our later
discussion.

With regard to economic development,
there are essentially two types of capital: debt and equity. Debt is capital
that an entrepreneur has to pay back. Equity is capital that an investor gives
up to become a part owner in the company.

Of the two types of capital, debt
is the most familiar and most common. Debt involves everything from
conventional loans from commercial banks, small business administration loans,
loans from USDA rural development and Cooperative Business Service, as well as
state, local and private revolving loan funds. While most businesses use debt
capital for start up and expansion costs, rural businesses are particularly
dependent on debt financing. Debt financing is relatively easily understood and
is more or less straightforward, making it a comfortable fit for a wide range of
people.

Debt has its limitations, however.
Bank consolidation has reduced the number of banks competing for borrowers and
the number of outlets for debt financing in rural communities. The expansion of
banking services offered has increased competition for deposits, which in turn
limits the funds available for a bank to lend. Furthermore, banks are sensibly
conservative when it comes to risk. While being risk averse is a good thing
from a bank management and survival perspective, in rural areas, it can mean
that unfamiliar, new, or risky new businesses cannot get the capital they need
to begin operation.

A very specific, and important, type
of debt financing that is growing in rural America is microcredit, or
microenterprise loans. Microenterprise represents a huge amount of economic
activity in rural areas. In Oklahoma, microenterprise account for 18.8 percent
of all employment, with about 275,000 microenterprises in operation. These very
small businesses operate in every corner of the state and contribute vastly to
their local economies. They have capital needs that are often very different
from other businesses, even small businesses. For a variety of reasons, these
entrepreneurs are often unable to access even the small amounts of capital they
require for start-up or expansion. Among these are their lack of credit
history, insufficient equity, limited business experience or simply the small
size of the loan. To fill this need, microenterprise loan programs extend small
amounts of capital (possibly as little as $500, and usually limited to $15,000
to $25,000) and bundle together business and management training to improve the
chances of the borrowers’ success.

Equity financing—investment
capital for businesses—is less available in rural areas than in metropolitan
places. Equity capital offers several advantages over debt capital for rural
businesses and entrepreneurs. Primary among these is the sharing of risk over a
greater number of people or entities. A secondary advantage is the involvement
of experienced managers in the process, which transfers valuable skills and
experience to rural businesses. Since most investors prefer to have a voice in
company operations and activities, equity financing also broadens the advice
available to and guidance for rural businesses.

Equity financing also provides
capital for new ventures that serve to diversify the economic base of an area,
since these higher risk businesses often have greater difficulty securing
loans. Diversifying the economic base in rural America is a big part of the
game plan, of course, but the lack of equity makes accomplishing this task much
more difficult. Access to this risk capital is unorganized and difficult for
rural entrepreneurs to accomplish—to such an extent that rural America is
largely locked out of the bulk of private investment capital available.

While debt financing is the most
commonly used path to access capital for rural development, equity financing
deserves perhaps more attention. Metropolitan entrepreneurs, businesses and
industries enjoy access to a wide range of investment capital, with roughly 90
percent of all equity investments going to metropolitan areas.

There are a handful of sources
for risk capital for rural economic development. Rural venture capital
funds are one. They operate like other venture capital firms, pooling
investment capital from a host of sources and reviewing business plans for solid
investments. Rural venture capital is very limited, but has become the focus of
much interest in recent years. The private market for venture capital in rural
areas is almost non-existent for reasons I will discuss later. The Rural
venture capital funds that do exist are often coordinated by community
development financial institutions—community development banks and the like—that
take a double bottom line approach to business.

Many states operate venture capital
firms for economic development in general. Oklahoma's Capital Investment Board
is a model program of a successful state initiated venture capital fund.
Because these institutions lack a specific rural mandate, they do relatively
little of their work in rural America.

Rural cooperatives
are another source of equity financing. They have been investing local capital
in projects in rural areas for generations. Value-added agriculture projects
and marketing of ag products have long been a staple of these institutions.
Recently, rural electric cooperatives, which have a ready surplus of capital,
have made some tentative investments in new ventures in their areas, usually
tied to new industry and economic development. There are a cautionary tales in
how far rural cooperatives can go to promote economic development, however, in
both the Farmland Co-op meltdown of a few years ago, which is often blamed on
the Co-op becoming overextended, and in the current rush among cooperatives in
the Upper Midwest especially to get involved in ethanol. Given the uncertain
nature of the ethanol industry, it concerns me that so much of the risk is being
borne by producers.

Another important category of equity
investors are known as angels, generally wealthy individuals who are
local to the entrepreneur or investments that they make. They may make smaller
investments than venture capital firms might choose to make, but are more likely
to support early-stage companies and are willing to commit more of their own
time and expertise and are more patient than conventional venture capital
companies. Some efforts have been made to bring these investors together
through Angel networks which help to put wealthy individuals with money to
invest in touch with entrepreneurs with capital needs.

Small Business Investment
Companies are SBA-licensed funds which can borrow
federal money to mix with private funds. They tend to tilt toward moderate risk
investments in nearby areas and are not well-represented in rural areas. The
SBIC model has been adapted to encourage activity in rural areas through the
Rural Business Investment Companies Program and the New Market Venture Capital
Program. The Rural Business Investment Company Program has not been funded,
however, and the New Market program has only seven companies enrolled, four of
which are in rural areas. It is unlikely that this program will be expanded.
This being said, the model is certainly there to build on for rural specific
programs.

Philanthropies and foundations
can be very involved in the financial profile of rural communities, although
they are often not comprehensive in their focus, national in their reach, and
can fulfill only part of the need. Foundations have demonstrated numerous
innovative strategies that have become extremely useful to states, including the
pairing of economic and social development activities and the use of broad
community coalitions to build local assets. State leaders can be very
influential in cultivating philanthropic support for rural development
activities, particularly as a number of large foundations begin to engage policy
handles related to their areas of interest.

The government plays an important
role in capital markets. These include serving as a source of capital, the
regulation of capital markets, and providing support services to banks and
borrowers, among others.

The government provides capital
in a variety of ways. The government can act as a direct lender through a wide
range of programs, including those for infrastructure, housing and industrial
development, as well as Community Development Block Grants, and a considerable
amount of USDA rural development funding and farm service agency money.

Governments at all levels can also
provide loan guarantees through a range of mechanisms. While not capital
per se, loan guarantees take the risk out of financing for all banks, while
helping the private sector serve rural businesses. Because the loan guarantee
reduces the amount of capital lenders are required to hold on outstanding loans,
these programs increase their liquidity, which is a major issue for rural
banks. The principal federal loan guarantee programs are the Farm Service
Agency, the Rural Housing Service, the SBA’s small business loan guarantees and
the rural business cooperative service. Housing remains the biggest part of
federal loan guarantees.

State and some local government
offices offer credit subsidies (especially for housing) as well as
linked-deposit programs, and interest rate subsidies to make capital more
affordable for targeted populations or activities.

Government plays some role in
providing venture capital, particularly through either seed capital for
venture firms with special missions, extending support to business incubators,
guaranteeing venture funds with state tax credits and investments of state
resources, such as state pension funds, in capital funds.

While it may seem too obvious to
mention, the role of state and federal government in regulating capital
is extremely relevant. State and federal securities regulations and rules guide
the application of capital to identified needs. Federal deregulation of the
banking industry in the 1990s led to interstate bank branching and increased
bank consolidation, a trend that is continues. The rules and regulations
guiding particular financial instruments and financial institutions can have
dramatic impact on the availability of credit and capital for economic
development and their geographic distribution.

States can often get involved in
financial markets through support services to banks and borrowers. These
include state programs on financial education, credit awareness and, recently,
identity theft. The extent to which these improve financial literacy increases
a communities ability to use capital to build assets. Rural communities in
general experience lower degrees of financial and economic literacy.
Credit-counseling services for low-income borrowers are an example of state
activity on the consumer end of this category of support.

The question arises as to why it
is so hard for rural places to access capital for economic development.
While the underlying reasons are far from simple, a few facts are well-known.
First among these is that, compared to metropolitan areas, rural businesses and
entrepreneurs have a smaller menu of financial products and often pay more to
access capital. Furthermore, given the array of options, it is unsurprising
that there is some confusion about eligibility, performance standards,
requirements and the like. This is equally true whether it is a rural
entrepreneur or business or a rural community.

Adding to this is increased
difficulty in locating the source of some of the less well established
programs. There are many options for capital, particularly loans, from state
and federal sources, but rural entrepreneurs and communities are often
ill-equipped to identify and access these in a timely fashion. Communities may
also find the application and reporting requirements for this capital difficult
to manage without outside support.

Another thing that rural communities
and their entrepreneurs face is competition with metropolitan areas for
capital. Metropolitan areas are where the banks have their main offices, it
is where the assets are, and it is increasingly where political clout is to be
found. Rural areas also have fewer sources of capital competing for their
business, which translates into higher costs, lower availability and fewer
options. Program rules for some economic development programs available through
state and federal governments provide place-based entitlements for larger
population centers, but offer only competitive grant programs for rural places.

Since venture capital is so vital to
building economies regardless of location, it is exceptionally vexing that
equity investors shy away from rural places. This is, however, not perhaps
too surprising. For venture capitalists, rural areas have several
disadvantages. Because of rural entrepreneurs are so spread out, venture firms
complain that it requires too much travel and time required to identify suitable
rural investments. This lack of density makes it hard to create sufficient
“deal flow” as well. Often, rural startups or expanding businesses require too
much operational assistance from venture capital firms. Rural America also
abounds in the “wrong” industries for venture capital, which prefers to flow to
new technologies and new industries with high rates of return. Venture firms
prefer 10 year cycles with expected returns of up to 30 percent. While a
high-tech future may be in the cards for some of rural America, the abundance of
natural resources in rural places points to a future that capitalizes on this
advantage. Unfortunately, venture capital for natural resources-based
industries is very slim. Rural firms and entrepreneurs, especially those
requiring significant levels of operational assistance, are unlikely to return
at such high rates and short cycles.

So what does rural America need
to get better access to capital for economic development? In short, we need to make sure that rural communities,
entrepreneurs, and businesses have a full set of tools that is the right size
for their needs, a full set of skills, and a level playing field.

State government and policymakers
play a major role in getting this done.

A few of the ways states can be
involved include providing capital; directing private and public capital toward
rural markets; leveraging federal funds; coordinating and facilitating private
and foundation investment; building social and human capital in rural places;
providing oversight and ensuring accountability; improving bank liquidity;
encouraging cluster development so rural entrepreneurs don't have to go it
alone; and coordinating and identifying resources and opportunities. Perhaps
most important of all of these it the state's role and responsibility to
coordinate rural policy and activity. States typically make large investments
of scarce resources in rural communities, and it makes good sense to make sure
that these investments are connected to economic development goals.

Provide capital

State
capital, loan guarantees and interest rate subsidies are very important
components of rural infrastructure in particular. States also play an important
role in supplying capital, often on very favorable terms, to CDCs who are then
able to extend credit in their communities. As state’s have sought to insulate
themselves from risks associated with loan guarantees and direct and indirect
lending, they have shifted to providing seed capital for revolving loan funds
and venture capital entities have grown, as has the use of tax-exempt bond
programs to build capital for specific purposes (mostly to expand housing,
mortgage, and industrial development) and linked-deposit programs (such as the
Oklahoma Rural and Affordable Housing Linked Deposit Program).

Direct private and
public capital to rural markets

Rural
markets are not particularly attractive to equity investors. Venture Capital
firms seek high returns on investments and have limited investment periods (30
percent and 10 years, typically). Rural areas abound in opportunities for
investment that won’t return at that rate and may need more patient investors.
Venture Capital Markets are in a marketplace where the slower growth industries
are neglected without help from outside, such as state guarantees of capital and
management assistance for rural ventures, linkages of public investment and
venture capital and the like.

State
pensions and retirement funds are a source of potential investment capital for
rural America. Arkansas has directed its state pension plans to invest in state
enterprises. Institutional investors—both public and private—should be
encouraged to invest in rural businesses, but will need help in identifying
local opportunities.

Tax
credits, loan guarantees, linked-deposit programs, gap financing and other state
vehicles for directing debt capital to target populations can be coordinated and
consolidated to ensure that rural communities know about and can access them
easily. Coordination at the state level through a rural ombudsman provides a
one-stop shop through which resources and training opportunities can be
identified and directed to where the help is needed.

Leverage federal funds

Coordinate/facilitate
private and foundation investment

Philanthropic investors play a major role in several states community
development financial institutions. The state is very well placed to court
these organizations and connecting local institutions with state, regional or
national philanthropic organizations.

Build social and human
capacity in rural places

Capital
flows to people and places where the human and social capital is greatest.
This can mean anything from increasing the percentage of rural residents with
college education to improving the business, accounting, and marketing skills of
rural entrepreneurs. Social capacity—the sum of the abilities, skills
capabilities of the institutions and networks in a community—help to build and
retain assets within a community. While these networks are often considered
organic, the state can play an important role in bringing groups and individuals
together and to facilitate the exchange of information across informal networks
to create a web of support for rural communities.

Technical
assistance enhances the credit-worthiness of the entrepreneur or business by
increasing the likelihood that a loan or extension of credit will be repaid.
Because these programs tend to improve the qualifications for recipients for
credit, they help to extend capital into typically underserved populations and
to expand business successes in rural areas. Technical assistance and operating
assistance is offered through a variety of programs and is often mandated for
participants in microenterprise loan programs. Federal and state programs often
offer technical or operating assistance as a component of credit as well.

Provide oversight and
ensure accountability

Economic
development activities often benefit from an outside perspective on activities
and challenges. State government, and particularly the Legislature, has a role
to play in setting objectives, guiding assistance, and ensuring transparency and
accountability. The states with the most successful rural development programs
are often characterized by a public, vocal and demonstrated commitment to
addressing rural needs by state leaders.

Improve bank liquidity

Rural
banks, for a variety of reasons, operate in a tight credit market. As rural
lenders have become more important as sources of credit for rural businesses,
money for loans has become less easily available. Remedies for this at the
federal level, including access to Farm Credit System and Federal Home Loan Bank
monies, require complex legislative fixes that are unlikely to come to pass.
The FDIC’s rewrite of the Community Reinvestment Act rules, which was intended
at least in part to remove some of the regulatory burdens on small banks, would
possibly increase liquidity among rural banks, but at the expense of credit
available to underserved populations.

Secondary
markets for banks is another option that is very underutilized in rural
America. Loan poolers or remarketers just do not operate in rural areas,
generally, which means that very few rural banks can take advantage of the
secondary market that exists for metropolitan banks. This is complicated by
high transaction costs and information costs for rural banks. These hurdles can
be overcome, but will require state and federal action to increase debt
remarketing activity.

Encourage cluster
development

Cluster
development has become the most commonly pursued economic development strategy.
Cluster development in rural places requires new thinking about what rural
places have to offer and can feasibly do. We’ve gotten to the point in economic
development that success means to bring in something new and not adding to what
is in place. The skills of that the community already has should be the
starting point in building economic development in order to honor what the
community already has.

Coordinate and Identify

Rural
communities are at a disadvantage in identifying, accessing and managing funding
from a variety of sources—state, federal, private and philanthropic. States
with coordinated networks for rural EDCs or central rural offices/centers that
serve rural communities are better linked and more capable of connecting
communities with opportunities.

With that as a backdrop, I'd like to
turn now to specific programs in place, I have selected a handful of
notable programs from outside of Oklahoma. These represent a mix of state and
private programs which serve as models for various approaches to rural
development.

One Georgia (tobacco funds, shifted from comprehensive model to
one that supports communities)

North Carolina Rural Center -Microenterprise Loan Program

and Capital Access Program/Business Loan Program
(provides a loan loss reserve to allow banks to make high-risk loans)

West Central Initiative (Minnesota) focuses on community and
family support and workforce development; comprehensive approach; builds human
and social capital

Rural Capital Advance (Federal Home Loan Bank of Des Moines)
operates in much the same way as the NC program, but demonstrates this approach
finding traction at a regional level.

Coastal Enterprises Inc. (Maine) CDFI—makes loans and
investments; natural resource based investments and affordable housing; links
development finance to building human and social capital

Economic Development Institute (Georgia) provides training and
assistance to communities to help them support their local entrepreneurs

Office of Rural Community Affairs (Texas) comprehensive rural
agency; direct state and federal resources and help to identify other sources of
funding or capital. ORCA demonstrates excellent coordination of resources and
serves as a “one-stop shop” for rural Texas and Texans.

Two other important resources:

Rural
Policy Research Institute Center for Entrepreneurship

Regional
Economic Development Research Laboratory, Clemson University—Dr. David Barkley